The use of derivatives in managing corporate risks
Financial derivatives are defined as the instruments which mainly derive the value that they have from the performance of the underlying foreign exchange rates, interest rates, commodity prices or equity. Many instruments and products are described as derivatives by the market participants and financial press. The financial derivatives come in very many forms and shapes that include futures, options, structured debt deposits and obligations, swaps, forwards among many others. Some are privately negotiated transactions whereas others are traded on the organized exchanges. These derivatives are slowly becoming an important part of financial markets because they are well able to serve various economic functions (Jorrion 2001 p, 23). The derivatives are used to expand the product offerings to their customers, minimize business risks, manage funding and capital costs, trade for profit purposes, and also to change the risk-reward profile of a whole balance sheet or a particular item.
The derivatives are valuable and legitimate tools for all banks and all corporate but they also contain risks like all other financial instruments that must always be managed. Financial derivatives should always be considered for total inclusion in all corporations’ risk-control arsenal. These derivatives allow for the effective and efficient transfer of the financial risks and they also can help in making sure that the opportunities that are value-enhancing are not ignored (Gupta 2003 p, 37). Financial risks on the other hand are the risks that occur to a corporation that emerge from price fluctuations that either directly or indirectly determines the value of the company in question.
Implementing and devising an efficient risk management strategy always involves various steps: the quantification and identification of the risk exposures; the design of the most available and well able instruments of risk management and also the assessment of their effectiveness; an assessment of the possible costs and benefits of the risk management; and finally the implementation of the selected strategy.
Derivatives are categorized broadly. These categories include the relationship that exists between the derivative and the underlying. This category has examples like swap, option and forward. The second category includes categorization depending on the type of underlying and examples in this case include interest rate derivatives, equity derivatives, credit derivatives or commodity derivatives, and foreign exchange derivatives. Te third category is according to the market that they trade in and here they include over-the-counter and the exchange-traded (Phillip & Kennedy 2004 p, 28). Finally, the derivatives can be pay-off profile where some of the derivatives have payoff diagrams that are non-linear because of embedded optionality. There are also the vanilla derivatives which are the most common and simple and also there exists the exotic derivatives that are specialized and more complicated. However, there is no definite rule that could be used to differentiate one from the other and the distinction is left to custom.
These are contracts that offer to give the right but not an obligation to the owner to either buy an asset in the case of call option or to sell an asset if it is in the case of put option. The price known as the strike price is the price at which the sales take place and is always specified at the time which the parties involved enters into the option. This kind of derivative specifies the expected maturity date. In the case of a European option, the owner will always have the right to need the sale to take place only on and after the maturity date. In the case of an American option, the owner needs the sale to take place at any time only up to the date of maturity. In case the owner of the given contract exercises the given rights, then the counter-party has the requirement to carry out the required transaction (Jarkko 2009 p, 102).
The person who attains the right is referred to as the option holder or option buyer while the person who confers the right is referred to as the option writer or option seller. The seller charges an option premium. Options are divided into puts and calls. In this case, a call option gives the possessor the right to purchase an asset at a given date for a given price but in put option, the possessor is given the right to sell the same asset at a given time and price. This given price that is specified is usually referred to as strike price or exercise price and the given date indicated in the contract is referred to as the maturity date or expiration date or exercise date (Gupta 2003 p, 59).
These are contracts used to exchange flows of cash on or even before the given future date on the value of exchange rates, commodities, other assets, interest rates/bonds or currencies that is underlying. A swap is described as an agreement among two counter parties to trade cash flows in future. The agreement contains dates when cash flows will be paid, the type of currency to be used and also the mode of payment. The calculation of the cash flows involves the expected future values of the market variables (Moorand 2006 p, 98).
There are two types of the swap contracts and they include currency swaps and interest rate swaps. The interest rate swap is where one party accepts to pay the other party interest at the fixed rate on an estimated principal amount for the given period. These two sets of the cash flows currencies are very similar. In the case of the currency swap, this involves exchanging of the interest flows in one currency and the interest flows in another currency. This requires exchange of the cash flow requires two currencies.
These are the contracts to sell or buy any asset on or even before the future date at a price that should be specified today. A forward contract is the simplified and customized contract that exists among two parties to sell or buy a particular asset at a particular times in the future for an agreed certain price. They are not always traded on an exchange unlike the future contracts but rather they are traded in the over-the-counter market, mostly between two institutions of finances or even among a financial institution and a client of the institution (Gupta 2005 p, 38).
The forward contracts are contracts that are bilateral and therefore they are always exposed to the counter-party risks. They are more risky than the future contracts because they are faced with a risk of the non-performance of obligation by either of the parties involved. Each of these forward contracts is custom designed and therefore they are unique in terms of expiration date, the contract size, asset quality and type. In these forward contracts, one of the parties involved takes the long position by first agreeing to purchase the asset at a given future date whereas the other party takes a short position by also agreeing to sell the asset at the given date for the same given price. In this forward contract, the party which has no obligation to offset the contract is always said to be in an open position. On the other hand, the other party is said to be in a closed position and also is referred to as a hedger. The given price that is specified is referred to as the delivery price. In conclusion, the forward contract is the agreement among the counter parties to sell or buy a given quantity of an asset at a given price, with the delivery at also a given time and place in the future (Bodie & Melton 1998 p, 92). These forward contracts are not standardized and each of the contracts is customized to the specifications of the owner.
This is an agreement among two parties to sell or buy a given quantity of an asset at a given price and at a given place and time. They are normally traded on the basis of an exchange that sets certain norms that are standardized for trading in the contract. These future contracts have features that include standardization, settlement price, clearing house, daily margin and settlement, tick size, cash settlement, regulation, and delivery. They are executed on the date of expiry.
Most of the future contracts are settled in cash because mostly the future prices are given in currency units with a least price movement referred to as the tick size. The prices are often rounded to the nearest tick. When one enters into a future contract, he is expected to deposit certain amounts with the broker referred to as margin.
Uses of the financial derivatives
The financial derivatives provide services in control, shift, manage, avoid efficiently and effectively the various types of risks that occur in the corporate through the different strategies like arbitraging, spreading and hedging among others. These derivatives also assist the owners to modify or shift suitably the threat characteristics of the involved portfolios. These kinds of the financial derivatives are useful specifically in the highly volatile conditions of the financial market such as highly flexible interest rates, erratic trading, monetary chaos and the volatile exchange rates.
The financial derivatives also serve as barometers of the trends of prices in the future and these will result in innovation of new prices both on the futures and the spot markets. They therefore also help in the dissemination of assorted information that regards the future markets trading of the different securities and commodities to the whole society. This in return would enable the discovery or the formation of a suitable or true or correct equilibrium prices in the targeted markets (Gupta 2005 p, 112). Due to this, we can conclude that the financial derivatives assist in superior and appropriate allocation of the resources in the society at large and in our research to the management of corporate risks.
Corporate risk management for organizations
Financial derivatives and their trading enhance liquidity and also the minimizing of the transactional costs that are in the markets for all underlying assets. This is brought about by the fact that in financial derivatives there is no trading that is done that requires an immediate full payment of the transaction amount because most of these derivatives are based on the margin trading. Due to this most traders, arbitrageurs, and speculators operate in these markets. Also most of the corporate operate in these markets and this reduces the levels of liquidity.
The financial derivatives help the traders, investors and managers of the large pools of funds to discover such strategies so that they may make suitable allocation of assets to increase their expected and actual yields. This would also help them to achieve various investment goals that they had planned in their year goals. The financial derivatives also help to smoothen out the fluctuations in price, they also squeeze the price spread, and they also integrate the price structure at various points of time. This helps to eliminate shortages and gluts in the markets and this helps a lot to manage the corporate risks because the prices will be standardized.
The financial derivatives and their trading encourages competitive trading in the existing markets, they also encourage diverse risk taking partiality of the market operators such as traders, hedgers, speculators, arbitrageurs among others often resulting in raising of the trading quantity in the country. The financial derivatives are also able to attract the young energetic professionals, investors and other expertise into the markets. These young people will act as positive catalysts to the positive growth of the financial markets.
The financial derivatives and their trading help to develop the markets towards the complete markets which are shown to refer to the situations where no given investor is known to be better than the other. The patterns of proceeds of the additional securities are known to be spanned by the existing securities and there is no scope of any additional security.
Types of derivatives
An equity derivative is described and widely known as a class of financial derivatives whose worth is at least partially derived from one or more equity securities that are underlying. Futures and options are the most popular equity derivatives though there are many others. The equity options are more common than the other types and they provide the right only but not the obligation to sell or buy a given quantity of stock at the given strike price within the specified period of time that is prior to the expiration date. There are the warrants which are securities that entitle the holder to purchase stock of the corporation that issued the warrant at the given price that is always higher than the stock price at the time it was issued (Carr & Madan 2001 p, 123). The warrants are used to enhance the yields of the bonds and they always make them more eye-catching to the potential buyers.
The convertible bonds are the ones that are converted to be shares of stock in the issuing corporations, mostly at the pre-announced ratios. They are hybrid security with equity-like and debt-like features. They can also be used by the investors to attain the benefit of the equity-like returns while still protecting the disadvantage with the regular bond-like coupons.
Most investors can make use of the equity derivatives in order to hedge the risks associated with the taking of a position in the stock by always setting the limits to the losses that are incurred by either a long or a short position in the shares of a company or a corporation. The investor is able to receive the insurance by paying the full cost of derivative contract often known as premium. If the investor buys the stock, he can protect it against a loss in the share worth by buying a put option (Gupta 2005 p, 19). There are five main types of the equity derivatives and these are stock options, single stock futures, warrants, contract for difference, and the index return swaps.
The single stock future is the contract that delivers often a hundred shares of the specified stock on a specified date in the future. The set market price for the single stock futures is based on the total price of underlying stock added up to the carry cost of interest then subtracting any dividends that are paid over the term of the specified contract. The trading single stock futures require a minimal margin other than the underlying stock because the investors always use a 20 percent margin to purchase them. This minimum margin gives more leverage to the investors than they benefit from the trading stocks. These single stock futures are not subject to daily trading restrictions.
The stock options are most popular and they provide the investors with a way to hedge the risk or even speculate by captivating on additional risk. They are centrally cleared and traded on exchanges and therefore they have transparency and liquidity working for them. The determining primary factors are time premiums which decay as the stock option move towards expiration, the intrinsic value which depends on the price of the stock that is underlying, and finally the stock volatility. The contract for difference is the agreement between the sellers and the buyers stipulating that the seller will recompense the buyer for the developing difference between the existing value of the stock and the value it will have when the contract will be made. When it is negative the seller is paid by the buyer. The purpose of the contract for difference is to permit the investors to conjecture on the movement of the underlying stock prices without necessarily having to acquire the shares. Their pricing is simple and there are a range of the underlying instruments (Gupta 2005 p, 67).
The index return swap is an agreement among two parties to exchange two sets of currency flows on pre-specified dates over the named and given number of years. One of the parties could consent to recompense an interest payment at a fixed rate whereas the other party consents to pay the overall return on an equity index or equity. The investors who seek straightforward path to gain total exposure to a given asset class, for example an index or sector portfolio, in an efficient cost manner always use swaps.
The active managers of the corporate may use swaps because they are an efficient way to increase or even decrease their exposure to the various markets over time. The fund managers always seek the exposure to an index and they have various alternatives. To start with, the fund managers could buy the whole index may be the S & P 500. This includes purchasing shares of each company in the index followed by changing the portfolio every time that the index alters and also as new money comes into the fund although this is very expensive. The other alternative is to make use of the equity index swap where the manager makes arrangements for an S & P 500 swap which there is an agreement on the interest rate to be paid for the swap. In return, the manager is able to receive the return on the index for the period that is stated. These equity swaps have tax advantages.
Property Derivatives for managing real estate risks in several countries especially in Europe
A credit derivative is defined as the securitized financial derivative whose worth is deriving from credit risk on an underlying loan, financial asset, or bond. The credit risk is always on an entity rather than the counterparties to the transaction. This entity is usually referred to as reference entity. They can also be bilateral contracts between the seller and the buyer under which they are protected against credit risk (Rohan 2007 p, 38). These are categorized into two: funded credit derivative and the unfunded credit derivative.
The unfunded credit derivative is defined as the bilateral contract that exists among the two counterparties and each of these parties is responsible for the making of payments under the agreement without necessarily recoursing the other assets (Gupta 2005 p, 39). A funded credit derivative on the other hand entails protection of the seller who assumes the credit risk and hence makes an initial payment which is used to settle potential credit events.